Understanding the difference between levered and unlevered free cash flow can help you make sense of the tools a company relies on to raise funds. This knowledge also can prove useful when reviewing the organization’s cash flow statement, an essential report that sheds light on such activities as operating, investing and financing initiatives.
Free Cash Flow
Free cash flow measures how much money a business can distribute to its external financiers. Financiers run the gamut from common stockholders and traditional bondholders to preferred shareholders and convertible security holders. This metric equals cash flows from operating activities plus cash flows from investing activities. Another way of calculating free cash flows is taking earnings before operating income, adding amortization and depreciation, and subtracting changes in working capital and capital expenditures. Working capital evaluates how much money a company will have in the next 12 months. It equals short-term assets minus short-term liabilities. Capital expenditures relate to purchases of long-term assets, such as equipment, motor vehicles and production machinery.
Unlevered Free Cash Flow
Unlevered free cash flow is cash a company generates before paying interest. The metric equals “earnings before interest, taxes, deprecation and amortization” (EBITDA) minus capital expenditures minus changes in net working capital minus taxes. The idea is to determine how much money the organization generates on a stand-alone basis before meeting its financial commitments. Corporate leadership reviews this metric to determine how adeptly department heads are using company money, making sure they thoroughly analyze opportunities before making commercial moves.
Levered Free Cash Flow
Levered free cash flow is unlevered free cash flow minus interest and mandatory principal repayments. In other words, it shows the net cash balance a company hoards after making all debt-related remittances. Investment bankers and financial commentators pay attention to levered free cash flow to see if a borrowing entity can still be economically afloat after satisfying its commitments. This observation is important to set financially moribund companies apart from organizations with a stellar credit history and economic soundness.
The whole conversation about levered and unlevered free cash flows touches on the steps and methodologies companies rely on to borrow, use loan proceeds to fund strategic initiatives and generate higher returns through those initiatives. The goal is to generate a return on investment higher than the loan interest rate, but also to show investors that department heads are thorough about what they know and always make sure to perform tasks well. In other words, free cash flow analysis often boils down to evaluating the dexterity with which department heads are able to spot profitable market trends and use loaned money to effectively exploit them.